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Monday, October 01, 2007

The Big Picture, authored by Barry Ritholtz is one of the most popular investment blogs going, and I often find Barry's work enlightening. But his obsession with "inflation ex-inflation" has got to stop. There are some good comments from Brad DeLong and KNZN on their respective blogs, but I feel compelled to chime in.

A central bank's job is to manage the money supply. Anything that has nothing to do with the money supply isn't the Fed's job. Keep that in mind.

Now let's assume that quantity demanded for a given good is expressed as a function of...

D = f (P, O, T, Y)

Where P is the price of the good, O is the price of other goods (compliments and substitutes), T is consumer tastes and preferences, and Y is nominal income. Note that Y is the only variable that would impact all goods in the same direction at the same time.

Thinking about the classic demand curve, changes in P cause movement along the demand curve, while O, T, and Y cause the demand curve to shift. Hopefully most of AI's readers took freshman microeconomics, and this all seems very elementary.

Now let's say that preference for some good, say corn, rises. Maybe Congress has increased the subsidy for ethanol, let's just say. Supply of corn is short-term inelastic, because it takes time to plant and harvest new corn crop. So the demand curve shifts outward, supply doesn't change much (if at all) and therefore the price of corn rises.

Now consumers of corn for food (as opposed to ethanol) will probably rotate into other food products, to the extent that corn has substitutes. So demand for wheat might expand, due to the O factor. And since wheat probably also has a fairly inelastic short-term supply curve, the price of wheat also rises.

So we have food prices rising, but having nothing to do with the money supply. Therefore reacting to this chain of events ain't the Fed's job. It makes no more sense to ask the farmer where to peg overnight bank loans than to ask the Fed to control agriculture prices.

Inflation comes from an increase in the money supply. If there is just more money floating around, this would manifest itself as a increase in Y. And remember that Y impacts all goods at the same time in the same direction. Perhaps not to the same extent, but at least in the same direction.

So let's say that in conjunction with the rising price of corn, the effective money supply has also expanded by 5%. Everyone has 5% more to spend, which causes all prices to rise by 5%. But corn and other food products actually rise by more than 5%, because of the shift in tastes. And somewhere some other price has to fall, or not rise as much, because the extra money being spent on food isn't getting spent someplace else.

Anyway, the Fed's problem is the 5% expansion in the money supply, not the increased demand for corn. Unfortunately, its difficult to peg exactly what the effective money supply is. And in real life, all goods face constantly shifting supply and demand curves. So the Fed faces a challenge in determining whether the money supply is increasing at a faster or slower rate than is desired.

In a perfect world, the Fed would look at a subset of goods for which O, T and the supply curve were all constant. It really wouldn't matter how representative those goods were, because the only thing that would cause the price to shift would be Y. The Fed could then determine if the change in price of this basket of goods was optimal knowing that the price change was due to changes in the money supply.

Of course, in real life, no such products exist. So the next best option is to strip out products which are known to have unstable supply and demand curves. This was originally the impetus for creating the "Core" CPI and PCE measures. Another way to handle this is to assume that the most volatile prices in a given period are being influenced by good-specific supply and demand factors and strip those out, whatever they might be. This is the idea behind the Dallas Fed's Trimmed Mean PCE and the Cleveland Fed's Median CPI estimate.

If the Fed is going to pick an inflation measure to target, we want them to target something that in most closely aligned with shifts in money supply and shifts in money supply alone.

Its fair for someone to say that their household bills are rising at a faster rate than any of the core inflation measures. Some of the items that have been rising in price most lately have been repeat consumables, like gas and food. But the Fed isn't targeting cost-of-living. It can't. So if you want to blame the media for ignoring cost of living in reporting on "core" inflation measures, fine. But don't blame the Fed.

Its not their job.

Posted by
Accrued Interest

33 comments:

Willie_T
said...

This analysis is great for freshman econ, and probably would be close enough for maybe the 1950s (when the US was effectively the whole world economy) -- but it really doesnt make sense in the real world.

The Fed creates money. If "all they gotta do" is stem the creation of money, the solution would be horribly simple: padlock the Fed doors closed. No new money, no new inflation. Problem solved.

Of course, the US doesn't exist on an isolated island -- and it must worry about so called exogenous events.

If the Bank of Japan is printing money like crazy, someone can borrow yen, buy dollars, and lend them to finance home purchases (directly or via buying mbs). If my home price goes up, I can go "create money" by taking out a home equity loan. I assume you are not going to try to argue that the Fed sterilized all home equity loans. Well, that means home owners equivalent rent failed to properly encompass home prices and the resultant surge in money supply.

Second, your suggestion that the prices of goods and services "doesnt count" (or is not in the Fed's purview) is a little deceiving. If it was merely a shift in preferences, then one good's price would go up (corn in your example) and some other good would go down (whatever the thing was that got substituted out). But your analysis fails when there are more goods with increasing prices than decreasing prices (tallied by their weight in a consumption basket). Things we spend a big percent of our consumption basket on (energy, shelter, food, healthcare, education) are going way up -- while things that are a rather small piece (HD TVs and computers) are going down. If it was mere substitution, things going up would be canceled by things going down. When you have the possibility for borrowing from "outside" the system (ie from abroad) -- your analysis breaks down.

And third, the money supply (measured by M2) is up 6-7% YoY (MZM is up over 13%). If money supply is the Fed's big thing, its going up by a lot more than CPI (and more than CPI + GDP too)

The Fed isn't trying to preserve the purchasing power of a dollar -- their mandate is to control inflation (the exact definition is left ambiguous) and promote growth (also ambiguous). In short its mandate can mean anything they want it to.

If you accept CPI as fact, the dollar has lost 50% of its purchasing power since 1983. The current CPI is set to be 100 for 1982-1984 (and is 100 for January 1983) -- was last reported as 207.917 as of August 2007.

To summarize, during the period widely accepted as the pinnacle of central banking success -- the dollar still lost half its value, even when measured using CPI (whatever its merits or lack thereof).

Can you name any CEO that would claim "success" because they cut the value of their company in half?

Finally someone speaks the truth. I'm surprised that the bear camp doesn't seem to notice how good of a job the Fed has been doing in the recent 10 years. The US won't be having an inflation problem. It's China's central bank that people have to watch out for. Isn't it funny to see the objective on their website is to maintain the currency?

For there to be an increase in demand for a good, there has to be the "wherewithal" to purchase the increased quantity of that good in the first place.

Where did that increased demand come from? Most likely due to "inflation".

Second, it has been conclusively proven that inflation does not affect all prices symmetrically. Putting it differently, the inflation effect is not a parallel shift. However, inflation causes the GENERAL price level (or the average price level) to increase. To capture the "inflation effect", you want to capture the "average" price, ex NOTHING!

Finally, the natural state of the world is a benign deflation, the result of productivity, technology and globalization. An inflation of 2% shows that the natural state of the world is being twisted away from its state of equilibrium.

Anyway, things are simpler than they appear. Fed is looking for psycological effect, nothing more. Greenspan talked about it. China will loose in case of recession. Inflation through rate cut (in fact 50 points led to 1% hit) is a small thing all things considered if you live in China and are looking to buy a dinner. GDP is way up and pork price is up too.

Fed is picking "lesser of two evils" and they are picking it right. Stupid investment bankers are all aroused over DJI bump, little they know that their dollar is sold half price. Good calculation on Fed's part to calm down 95% of fools out there.

You wrote: "A central bank's job is to manage the money supply. Anything that has nothing to do with the money supply isn't the Fed's job."

What nonsense.

Please cite any law or Fed publication that says such a thing.

While you are searching, try this FRB(SF) website:http://www.frbsf.org/publications/federalreserve/monetary/goals.htmlwhich states:"Monetary policy has two basic goals: to promote 'maximum' sustainable output and employment and to promote 'stable' prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act."

Achal: Say that CPI is a basket of 10 goods weighted equally. The money supply rises by 10%. From $1000 to $1100 to make the math workable. Before the rise in money supply, exactly $100 was spent on every good.

Say that the price of good #1 rises by 100%, but the quantity demanded falls by 50%. So in T=0 let's say that the good was priced at $1 and 100 units were purchased. In T=1, the price is $2 but only 50 units are purchased, for $100 spent on that good.

The other $1,000 is spread among the other 9 goods, or about $111 spent on each. Previously there had been $100 spent on those 9 goods, so there has been an 11% increase in the price of this good.

So what's our average price increase? Good #1 rose by 100%, and the other 9 by 11%, for an average price increase of 19.9%.

In this case, is the average telling the real inflation story?

Now you say, wait a minute! Shouldn't they adjust the basket to reflect the change in Q for good #1? Sure, but does the BLS actually do this every month with CPI? And are we certain they are really capturing all the changes in consumer behavior every time they do change the mix?

John Walker: Watch yourself. If you have a point, great. Don't call anything nonsense. We don't serve that kind here.

You are obviously right about what the Federal Reserve Act says, but the tool the Fed is given is monetary policy. They aren't given authority to say, mandate agriculture price caps. Or force farmers to change crop production. Not that I'm advocating anything like that, I'm just saying if the price shifts for some reason other than monetary policy its outside of the Fed's purview.

Calculating the rates of change in the CPI has been statistically exaggerated by the present practice of calculating the rates of change in terms of a base one year earlier, rather than from the base period of the index. For example, when I first started driving the base period for the CPI was 1967 = 100. Consumer prices in 1967 have increased 623% in terms of base year prices. In other words, a very substantial absolute increase in prices. But the base period keeps changing. Now the reference base period is 1982-84 = 100. And that assumes that the CPI is representative, which, as everyone knows, it is not.

With the exception of hyperinflation, all the “flations” are the consequence of “too much money chasing too few goods and services”, or the opposite. Inflation represents a chronic “across-the-board” increase in prices, or, looking at the other side of the coin, depreciation in money. If the depreciation of money is the consequence of a loss of confidence in the credit worthiness of the government, we have hyperinflation. The ultimate hyperinflations result when the existing government is destroyed, making its currency worthless - a 100 percent depreciation. There are, of course, degrees of hyperinflation.

It is a truism that if the flow of money in the market place increases relative to the flow of goods and services offered for sale, prices on the average will rise. Therefore, to say that a cartel or monopoly that posts a higher “administered” price causes inflation has to be premised on the assumption that the monetary authorities respond to such price fixing practices by increasing the volume of money and/or the public responds by increasing the rate of flow (transactions velocity) of money. The same reasoning applies to increases in wages achieved through the monopoly powers of a union. These price increases will result in a transfer of purchasing power and wealth to the groups with dominant economic powers. The resulting price distortions will weaken and depress the economy, increasing unemployment and ultimately creating a deflationary effect.

If the response of the monetary authorities is to provide additional legal reserves to the banking system, resulting in an expansion of bank credit and the money supply, other prices will rise and the monopolistically created prices will be “validated”. This obviously may lead to an “administered” price ---credit money spiral, and we have the core of chronic inflation. If the monetary authorities try to compromise the situation and reduce the rate of inflation, we end up with stagflation. But this is preferable to an all out monetary effort to create full employment irrespective of the inflationary effects. For if the rates of inflation increase, so will interest rates; and high interest rates alone are a sufficient factor to induce a severe recession or even a depression.

In other words, the powers of the Fed are limited. The solution to this problem is to eliminate, or sharply reduce the economic powers of monopolies, oligopolies and any other form of concentration of economic power. How to do this without the creation of an authoritarian state has yet to be discovered.

Imagine your politican twin accruedvotes was elected president of Freedonia.

Accruedvotes figures that nominal GDP of Freedonia will grow about 6% p.a. and thats made up of 4% inflation and 2% growth. Thats not great so accruedvotes lets it be known to his independent central bank that it would be great if the figures came out as 2% inflation and 4% growth. There's no independent body to verify the figures so it doesn't get questioned apart from in some obscure blogs.

The policy has some beneficial effects for accruedvotes:1. Instead of looking mediocre the economic figures now look great.2. Theres less pressure for wage increases from unions etc3. Corporate profits are good.4. Some of accruedvotes most important backers - the hedge funds, have a very nice tailwind when calculating the 20 in the 2 and 20. In fact the higher inflation is the better, so long as no one notices.5. Since "growth" is high and "inflation" low, Freedonia can run a large deficit financed with low yield bonds6. In spite of the high "growth" and low "inflation" , accruedvotes ratings for his handling of the economy of Freedonia get lower and lower as his reign continues. Analysts struggle to explain this conundrum.

FBeck: Obviously this is my evil twin since no one would ever cook up such a scheme in real life.

Look, even if you don't buy fbeck's conspiracy theory, its clear that CPI has many problems. Its a little like the DJIA. We all know that something like the Wilshire 5000 is a superior measure of broad stock market performance, but the Dow lives on out of inertia. Trimmed Mean PCE is too hard for the average newspaper reported to explain, so the media sticks with CPI.

The Fed needs to get out of the interest rate mgmt business period. Your piece inadvertently makes the case that inflation is impossible to measure precisely and "fine tune". Why not just increase the Monetary Base by a constant 2% a year and let the market determine all the rates?

Hi tddg,I don't know if I would call that a conspiracy theory.In the private sector we have independent board members, independent auditors, Sarbanes Oxley, (maybe) shorts etc and still investors are wise to view accounts with a sceptical eye. The public sector has none of those safeguards so their figures should be treated accordingly.

Conspiracy theory was more derogatory than I meant to be. I wish more people understood that government statistics are designed to measure a particular thing. Yet the media uses them to measure something else. Like CPI was designed to be a cost-of-living index, hence by the BLS calculates it.

I'm a little disappointed that you think D is an increasing function in Y for all goods and services. Indeed there are "inferior goods" for which demand moves inversely to income. Think bus rides, shoe repair, payday loans...

Barry plays to a huge audience of Tin-Foil Hat conspiracy theorists who read Catcher in the Rye all day long .... they find nothing positive about the economy , statistics , economic indicators and the markets ...

BUT as long as they are in full force , 100% negative , they are the best Contra-Indicator I've ever seen on all blogs

Now now... let's not be mean to the #1 finance blogger going. His blog gets 25 hits for every 1 I get.

Barry:

Thanks for commenting. In my admittedly stylized example, if the Fed increases the money supply by 5%, someone must have 5% more money to spend. I mean, the money isn't printed and then put into a vault.

I wasn't trying to say that the money supply has in fact risen by 5%, therefore what has happened with wages in real life goes beyond the story I was trying to tell.

Additionally, if the price of some goods are rising for non-monetary reasons, and the Fed tightens the money supply in response, then what we'll have is deflation. Because the conditions which caused the good in question to rise aren't going to reverse because money is tighter. But other goods will indeed react to the tighter money.

Finally, I ask all readers to stop inferring things from my posts that I don't actually say. I never said I didn't care about inflation or thought it wasn't a problem. I just don't think we should be measuring inflation using headline CPI.

tddg: You are absolutely right - the 19% calculation is not right. But I thought the point that you were trying to make is that it is ok for the Fed to measure inflation by leaving out certain "non-core" items.

To do that, you showed that an increase in demand for corn will cause a spike in the price. You then inferred that the rise in food prices had nothing to do with an increase in money supply.

My point was that your initial thesis was incomplete. The increase in food prices in your example was due to the increase in corn prices, which was due to an increase in corn demand, and that INCREASE IN CORN DEMAND WITHOUT AN OFFSETTING REDUCTION IN DEMAND ELSEWHERE was due to increased money supply, i.e. inflation.

The exact rate of inflation, as you point out, is difficult to capture. But I don't see how that implies that leaving out "non-core" items is the solution.

hymas - no, not saying anything good about Japan. Think you have me confused with someone else.

I am saying that, according to CPI, the dollar has lost half its value during a period the Fed and economists said was a golden age of central banking. I am saying with "wins" like that, who needs a loss?

For the record, I agree with tddg that CPI is probably "correct" for what it is supposed to measure -- I just don't think "what it is supposed to measure" has anything to do with inflation. I am not really sure it has any use outside its "official" duties. If so many things weren't tied to it, I doubt anyone would pay attention-- its a rather meaningless statistic.

I wasnt saying anything about Japan. But since you asked, Japan does not have an independent central bank. Yes, I read the propaganda pamphlets. But it is staffed and controlled by the LDP, and really isn't independent. I won't argue that the ECB or Fed are 100% apolitical, but they at least keep up a pretense of independence from the political establishment.

Achal: My problem with "core" measures is that they arbitrarily leave out energy and food. I prefer either a trimmed mean or median approach, which in essence leaves out whatever seems to be an outlier in a given period.

One risk that the Fed runs is creating higher inflation expectations because food and energy prices are rising so quickly. If you believe in inflation expectations theory, then it might make sense for the Fed to have some level of concern over headline figures, because its the headline that creates expectations. The Fed has said as much in various speeches lately.

I often find Barry's work enlightening. But his obsession with "inflation ex-inflation" has got to stop.

I used to love reading his blog, but it is increasingly fixated on this single topic. I don't like name calling between bloggers, but I think Delong said what is on a lot of people's minds.

You get brickbats for the following comments:

"A central bank's job is to manage the money supply. Anything that has nothing to do with the money supply isn't the Fed's job."

"You are obviously right about what the Federal Reserve Act says, but the tool the Fed is given is monetary policy."

On the first quote, another commenter already pointed out that the Fed has a dual mandate.

On the second quote, the Fed's toolkit is not strictly limited to interest rate policy. They are also responsible for bank regulation.

I don't mean to pick on you, however with Greenspan's book it is a topic du jour. I find it highly disingenuous for him to claim that he would have not been able to address the housing bubble without raising rates such that it would hurt the broad economy. That's nonsense, and I would respect the honest answer that Greenspan simply did not place much faith in government regulation.

I reiterate that I am not trying to pick on you. Rather, I find it annoying that Greenspan gets a free pass on this point. I think it is a case of something that gets said so often, that it becomes something that is taken uncritically.

Michael said... Why not just increase the Monetary Base by a constant 2% a year and let the market determine all the rates?

An increase in currency (an expansion in the "monetary base") held by the non-bank public is deflationary (will cause a contraction in money & bank credit) unless offset by open market operations of the buying type. The "monetary base" [sic] is not a "base" for the expansion of the money supply.

Commentors here have criticized my readers, they have dissecting my career (poorly and inaccurately), and have made other unsupported assertions -- but I can't say that anyone has effectively rebutted my main points:

-CPI inflation consistently understates real world inflation;

-focusing on the core (i.e., ignoring food and energy) is helpful to formulating policy;

-this understatement has had real world repercussions.

I know its easier to go ad hominem, but how about actually taking a shot at the main premise of inflation ex-inflation? At least your host here made an attempt . . .

Barry: I'm sorry for the ad hominem bull shit, which you know from my personal comments how I feel about that. I think we're going to have to agree to disagree on this.

On Greenspan: I shouldn't have said that their "only" tool is monetary policy. I meant this in context of inflation fighting only. They obviously have banking regulation responsibilities and I agree that Greenspan could have done something about subprime lending. Maybe he didn't want to or didn't think it was the right thing to do. But to say he couldn't have done anything about it is just not true.

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.